Thursday, February 16, 2012

Some people apparently interpreted this post as a shot at Chris Dillow's support of labor (more specifically, that I essentially accused him of being a "bourgeois apologist"). It wasn't intended that way, and as his latest post hopefully makes clear it wouldn't have been applicable in any case (in fact, in many ways his views go quite a bit beyond my own):

Cameron has said: “I do believe government has the power to improve wellbeing.” If this is so, then you’d expect a big part of public policy to focus upon how to improve the well-being of the unemployed. This is because these are, on average, significantly unhappier than other people - even the divorced - and it is probably easier to make the unhappy averagely content than it is to make the happy ecstatic.

But the coalition is not obviously solicitous towards the well-being of the unemployed. It prioritizes placating ratings agencies over creating jobs; its lackeys insult those who have suffered unemployment; it harasses the unemployed into workfare even though such schemes are of questionable efficacy; and it does little to combat a mindset that sees the poor, rather than poverty, as disgusting.

This inconsistency between a concern for well-being and a lack of concern for the unemployed is not, however, simply an intellectual failing. It reflects the fact that capitalism* requires that there be not just unemployment but that the unemployed be unhappy. I say so for three reasons:

1. Capitalism requires an excess supply of labour in order to bid down wage growth and industrial militancy. When Norman Lamont said unemployment was a “price well worth paying” to get wage inflation down, he was just blurting out the truth seen by Kalecki 50 years earlier - that “unemployment is an integral part of the 'normal' capitalist system.”

2. Capitalism needs the unemployed to look for work - to be an effective supply of labour. This requires that they be “incentivized” to seek jobs by meagre unemployment benefits and by being stigmatized. In other words, the unemployed must be made unhappy.

3. Blaming the unemployed for their plight serves a two-fold function in legitimating capitalism. It distracts attention from the fact that unemployment is caused by structural failings in capitalism, sometimes magnified by policy error. And in promoting the cognitive bias which says that individuals are the makers of their own fate, it invites the inference that, just as the poor deserve their poverty, so the rich deserve their wealth.

In short, in terms of attitudes and policies towards the unemployed, there is an ineliminable tension between capitalism and the promotion of well-being.

* Note to right-libertarians. By “capitalism” I do NOT mean “free market economy” but rather a system in which large companies are run for profit by hierarchical structures for the benefit of a minority of people (which only sometimes includes shareholders).

In comparative economic systems -- to some extent a dying field -- a distinction is often drawn between state capitalism and state socialism. Both are capitalistic at heart, but under each system the government owns industries such as railroads and the post office.

State socialists run these enterprises to maximize social good, e.g. the post office might be forced to deliver to unprofitable areas if the social good from doing so is large enough. Thus, profit maximization is not necessarily the main goal of state socialist governments.

State capitalists would operate these enterprises to maximize profit. A railroad would only go to areas where it is profitable, social considerations are off the table.

It seems to me that at least some aspects of the debate between Democrats and Republicans on how to run the government is really a debate over how the government should operate the enterprises it has control over (e.g. public goods). Should the government maximize profit, including outsourcing to the private sector whenever it might save a penny, or should social goals play a large role in how these entities are operated?

But this is, admittedly, a pretty unfamiliar area for me so I'm mostly fishing for comments and hoping to learn something from all of you ...

"I believe the most likely outcome is that the Fed will live up to its commitment to keep rates low through 2014." But if the economy continues to show improvement and prices begin ticking upward, that's not assured.

"When Romer showed [Larry] Summers her $1.8 trillion figure late in the week before the memo was due, he dismissed it as impractical. So Romer spent the next few days coming up with a reasonable compromise: roughly $1.2 trillion," Scheiber writes…. [W]hen the final document was ultimately laid out for the president, even the $1.2 trillion figure wasn't included. Summers thought it was still politically impractical. Moreover, if Obama had proposed $1.2 trillion but only obtained $800 billion, it would have been categorized as a failure. "He had a view that you don't ever want to be seen as losing," a Summers colleague told Scheiber….

The most persistent internal division inside the White House, however, was between the deficit hawks and those who believed more stimuli were needed…. Orszag, writes Scheiber, "worried that the sheer size of the stimulus could undermine the confidence of businessmen and money managers." In the subsequent year, when other advisers argued that an additional dose of stimulus would prop up a staggering economy, he downplayed the potential impact….Summers fought Orszag's pursuit of a deficit reduction commission…. He also pushed back on Orszag's idea of a domestic spending freeze, insisting the cuts would be too close to the bone.

"We're Democrats," Summers harrumphed. "We believe in these things." Besides, both ideas struck him as gimmicks unworthy of a president…. Orszag, in turn, so distrusted Summers' influence that, as Scheiber writes, he "enacted a special rule for Summers's deputy, Jason Furman: anyone receiving an unsolicited inquiry from Furman was to alert Orszag's chief of staff, Jill Blickstein."

In the end, however, only one economic adviser truly argued that deficit reduction should be put off for another day. And by the time the 2010 elections were over, even Obama's top political advisers were arguing that Christina Romer's position was utterly untenable.

[Top Adviser David] Plouffe urged the president to give [entitlement reform] a shot. "I said he [Obama] should be big on entitlements," Plouffe told one former administration official, by which he meant reining in these budgetary elephants. Sure, this would enrage the party's base. But the political upside with the rest of the country would more than make up for it ... "Plouffe is pretty big on accomplishments trump normal politics," said one White House colleague. "Plouffe's view is that big trumps the little."…

[W]hile internal staff disputes did play a role, Scheiber ascribes blame ultimately to the president. As he concludes:

[T]he Jobs Act punctuated the chronic confusion about the connection between politics and governing. Too often, the two activities were treated as an either-or proposition in the West Wing. Obama generally believed the way to pass his program was to engage earnestly with the opposition, not take his case public. A president never has more leverage with Congress than when he's riling up voters, but Obama rarely exploited the massive stature of his office as a tool for influencing legislation.

If Obama goes go "big on entitlements," it will be a mistake. People don't object to the benefits they receive. They like Social Security and Medicare. The worry is that these programs won't be there for them -- politicians have scared them into believing they might not be. After paying into programs like Social Security for so many years, middle class America feels entitled to the benefits they have been promised. But people have been made to believe that others are stealing this future from them -- lazy, schemers who live off the government in one way or the other -- and that's what they want eliminated, the "undeserving others". But keep your hands off their Medicare and Social Security.

I've complained many times that the risk of non-traditional bank runs in the repo market, a key factor in the financial crisis, is still present. As noted below in a quote from the NY Fed, the "systemic risk associated with this market remains unchanged." So it's good to see that the NY Fed is finally stepping in with oversight of this market after it waited for the industry to fix itself, and that didn't happen. But why did anyone think the industry would fix itself in the first place?:

At issue is the state of the triparty repo market. This sector is the backbone of bond trading... And because the market is dominated by short-term activity, a loss of confidence in a particular firm can kill its access to credit and potentially kill the institution, which can, in turn, create problems for the broader functioning of financial markets.

The effort to repair the market came to a head Wednesday with the release of a report by the Tri-Party Repo Infrastructure Reform Task Force, a private industry group operating with the support of the New York Fed. The report was to offer the group’s final recommendations, but that was evidently more than participants could manage.

Although the task force has made recommendations to improve trading in the repo market, the implementation of them “will require more time and technical implementation than the Task Force originally estimated and will constitute a multiyear project,” the report said. ...

In a related release, the New York Fed was clearly disappointed by the lack of traction the industry’s effort at self-reform had achieved.

“Despite these accomplishments, the amount of intraday credit provided by clearing banks has not yet been meaningfully reduced, and therefore, the systemic risk associated with this market remains unchanged,” the New York Fed said in a statement.

As a result, the bank said it “will intensify its direct oversight” of the triparty repo market. ...

Oversight is one thing, taking action is another, so we'll see what the NY Fed actually does. But at least there's finally some chance of movement on this front.

...there might be a silver lining here. It could that one pleasant legacy of the 1930s depression was a favorable unemployment-inflation trade-off in the 1950s and early 60s. This was because workers who remembered the depression were scared of unemployment and so did not press for large wage gains even though they were in a strong labor market. The upshot was that inflation stayed low. However, as workers who remembered the 30s retired and were replaced by workers who had known only full employment, risk aversion and the fear of unemployment receded and so wage militancy rose.

It might be, therefore, that in 20 or so years time, we’ll enjoy low inflation if we get an economic boom because today’s joblessness might permanently reduce wage militancy (or an inclination to get into debt).

This, I suspect, is the best that can be said in favor of present economic policy.

Yes -- if we can just crush the working class and its demand for a fair share of the gains from growth, prosperity will be just around the corner.

Again With Potential Output, by Tim Duy: St. Louis Federal Reserve President James Bullard graciously responded to my most last post regarding his much considered speech. I actually do not enjoy drawing Bullard's attention, in that it makes me fear that one day I will find that my access to FRED has been disabled.

On what Bullard and I agree on is this: There are different estimates of potential GDP. I discussed this point last year:

Now, before you roll your eyes, as I am inclined to do, note the CBO estimate of potential output is not the only estimate. Menzie Chinn reminds us of the variety of estimates of potential output, some of which suggest that, at the moment, the output gap is actually positive.

In that post I discussed some possible reasons we might consider a downward shock to potential GDP. Near the end, I concluded with this:

While not discounting the probability that some structural factors are at play, the primary challenge facing the US economy is insufficient demand. Optimally, I think the best solution to this challenge is that demand emerges from the external sector – and here I mean NET exports, export and import competing industries. This source of demand would support needed structural change, ultimately for the good of the US and global economies. This adjustment requires a relatively complicated expenditure-switching story on a global basis. I don’t know how to avoid such a story. Barring this outcome, one falls back on fiscal policy, which can surely do the job, but risks maintaining the current pattern of global imbalances. And perhaps such concerns are overblown; after all, so far the fears of a Dollar/current account crisis have not emerged.

Bullard takes a different approach. First, he rejects the CBO estimate offhand because it is not the outcome of "full DSGE model" and "there is nothing about the CBO potential calculation that allows "bubble" levels of output." Before we reject the CBO model outright, it is worth considering it basic effectiveness as a guide:

I see two recent episodes of output in excess of CBO potential, both of which were associated with what I believe were asset-price bubbles and also induced monetary tightening to stem inflationary pressures (which seems to contradict Bullard's assertion that the CBO estimate leaves no room for bubbles). If this was a significant overestimate of potential output in during the housing bubble, I would have expected more severe inflationary pressures.

Of course, even if the CBO estimates were roughly correct during the bubble, perhaps there has been a significant downward shift in potential. And here again I think Bullard and I can find common ground - potential output is not a measured variable, it is estimated. We really shouldn't blindly follow such estimates, but instead look for corroboration in other data. I tend to fall back on unit labor costs for a signal that wages pressures are outstripping productivity growth and threatening to sustain an inflationary dynamic:

I don't see a reason for concern at this point. But put aside the CBO estimate for a moment, and move onto the crux of Bullard's argument:

If households and businesses had ignored the house price developments as a sort of amusing side show, it would not have been so important. But our rhetoric about the decade suggests otherwise. Households consumed more through cash-out refinancing, developers built more, borrowing increased, Wall Street produced new financially-engineered products to feed the boom, and ancillary industries like transportation thrived. Output went up, and labor supply was higher than it otherwise would have been.

There are two parts to this theory. One is a demand side story - the debt-fueled housing bubble supported consumption and investment, supporting actual GDP growth. I don't think anyone disagrees with that view. The second part of the story is supply side, that the extra activity induced additional labor supply. With the housing bubble now popped, all of the related output and labor supply now melts away:

So, what Irwin's picture is doing is taking all of the upside of the bubble and saying, in effect, "this is where the economy should be." But that peak was based on the widespread belief that "house prices never fall." We will not return to that situation unless the widespread belief returns. I am saying that the belief is not likely to return--house prices have fallen dramatically and people have been badly burned by the crash. So I am interpreting your admonitions on policy as saying, in effect, please reinflate the bubble. First, I am not sure it is possible, and second, that sounds like an awfully volatile future for the U.S., as future bubbles will burst once again.

Now, I agree that the bubble cannot be reflated, nor should it. But this leads into what I don't like about Bullard's story housing bubble story. From my post last July:

Also arguing for a largely demand side explanation to the current weak employment numbers is what looks like a pretty obvious link between asset bubbles and full employment over the last decade. As long as households had a mechanism to support demand, achieving full employment was not a problem. If not households, then why can’t another form of demand fill the gap?

In Bullard's model, the housing bubble popped, and millions of people who were employed are no longer employed, nor should we expect them to be employed (or to reenter the labor force) as there is no way to do so absent another bubble. This seems to me an obvious place for fiscal policy and monetary policy to step into the breach and compensate for the lost demand. That millions of people's labor and output be lost simply because they no longer believe that housing prices don't always rise is a gross waste of resources.

You can tell a story in which that bubble-driven demand was necessary to compensate for negative equilibrium interest rates for risk free assets (driven by excessive saving by Asian central banks and aging demographics in the developed world). Rather than wait for another asset bubble to come along and lift demand, or twiddle your thumbs hoping another recession doesn't hit while you are at the zero bound, you could pull out the old-Bernanke playbook and implement an even more aggressive mix of fiscal and monetary policy to compensate for the lost demand and flood the world with risk free assets.

Now, as to Bullard's appeal instead to a New Keynesian framework, I am more sympathetic. Basu and Fernald opine:

..the major effects of the adverse shocks on potential output seem likely to be ahead of us. For example, the widespread seize-up of financial markets has been especially pronounced only in the second half of 2008. We expect that as the effects of the collapse in financial intermediation, the surge in uncertainty, and the resulting declines in factor reallocation play out over the next several years, short-run potential output growth will be constrained relative to where it otherwise would have been.

This is similar to my thoughts that somewhere in the background there is need for some structural change, toward export and import competing industries. That said, I still find it hard to believe that this is the primary story given that the downturn negatively affected employment across almost all industries. If structural adjustment was the primary issue, I would have anticipated a narrower range of affected industries.

Bottom Line: Bullard and I agree that there are different estimates of potential output. I think that if he wants to throw out the CBO estimate, he needs to provide another estimate to serve as a policy guide. And I would agree that any estimate, CBO included, needs to be continuously monitored in the light of actual incoming data. I still disagree with his asset-bubble model of potential GDP shifts. At its core it is a demand story with maybe a second-order labor supply aspect, and does not explain why no other source of demand can compensate for the lost housing bubble and induce higher labor supply. In the past I have considered reallocation stories similar to what can be derived from a time-varying NK measure of potential output, but again question that this is the primary concern at the moment.

And if you just can't get enough of this debate, Barkley Rosser argues there are arguments in favor of Bullard's position.

Let me add one note of my own. Bullard argues that the difference between the flexible and sluggish price outcomes in a New Keynesian model, measured by the difference between the "sticky price and flexible price level of output," is superior to the standard output gap measure. I have no argument with that in the context of a standard NK model. However this measure is based upon the assumption that Calvo type price rigidity (or something similar) is driving economic fluctuations. If this is not the way in which shocks are being transmitted to the real economy in this crisis, then this measure may not be the right index for setting monetary policy. I think stickiness in housing prices is part of the story, and perhaps wage rigidity as well -- so price stickiness is part of the slow recovery (though it's not clear that housing really fits the Calvo framework) -- but I'm not convinced this fully captures the breakdown in financial intermediation, balance sheet losses, and solvency/liquidity issues (for banks, businesses, and individuals) that characterized the recession, and that are still holding back the recovery. If we haven't captured the important ways in which shocks are affecting the real economy in our models, then the models won't serve as effective guides to policy.

Tuesday, February 14, 2012

Why aren't we doing more to rebuild our infrastructure at a time when our needs are high and borrowing costs, labor costs, and other costs of infrastructure are at bargain prices? Not to mention the employment benefits that would come with enhanced infrastructure investment. And why aren't we doing more to shore up our financial infrastructure through new regulations and oversight of the banking sector so that the problems we are having presently are less likely to reappear? There have been some changes in financial regulation, but not enough, and the financial sector is doing its best to block any further progress in this area:

As we sit mired in the Great Recession, Alexander Field’s exciting reappraisal of the Great Depression offers surprising solace. By showing the Great Depression was coupled with the most rapid technological advance in U.S. history, he fundamentally recasts the history of the 1930s. But he also offers hope that our own depression likely will have no long-run costs to the U.S. economy.

By measuring total factor productivity (TFP), or the improvement in productivity not accounted for by traditional inputs, Field finds tremendous gains during the Depression. They owe in part to private investment in manufacturing efficiencies, chemical processes, and other technical improvements. Historiographically, there’s a major payoff in showing that the vast majority of such innovation came during the Depression, not during the war.

But (as the bulk of Field’s book is devoted to showing) the productivity improvement owes mostly to construction transportation infrastructure – to the construction of roads, bridges, and all that made the modern trucking industry possible. Field even goes so far as to say the end of the golden age of productivity in the American economy in 1973 “coincides with [he does not quite say owes to] a tapering off of gains from a one-time reconfiguration of the surface freight system in the United States”.

And this massive public investment in infrastructure, which made possible the postwar suburbanization and boom, went along with financial regulation. Field attributes both the current crisis and that of the 1920s to “a failure to control, or really to be interested in controlling, the growth of leverage.” If we want to come out of the Current Unpleasantness with less than a Great Depression to show for it, we’ll have to see regulation that responds accordingly, he says. “If an even more serious crisis occurs within the next decade, it will be because the regulatory response ended up being less effective than that which was summoned during the New Deal.”

Which makes Field sound a lot less optimistic than Greg. The Great Depression turned out relatively well in the long run because we had not only significant private investment in R&D and other improvements, but also the New Deal – road-building and regulation. Do we have that, or anything like it, now?

Five years ago we had two million more people employed in manufacturing than we do today. Has the social fabric become so depleted in this period that these people or others could now not fill these jobs if they came back? If Brooks really thinks that the ill effects of unemployment are that extreme he should be screaming for more stimulus in every column.

I think Brooks is wrong about the cause. It's not moral decay of the middle class, it's the desperation that comes with lack of opportunity, and the lock-in that comes with some of the solutions to that problem. But I will note that I have been emphasizing the social value of keeping people connected to the labor force through temporary jobs programs since the onset of the recession.

This is a letter from James Bullard, president of the St. Louis Fed, in response to this post from Tim Duy:

14 February 2012

Dear Tim,

I appreciate your commentary, and all the commentary, on my Chicago speech from last week. I take the gist of these comments to be "you didn't show us a model." That is fair enough, I did not. (Readers may also wish to check Scott Sumner, Noah Smith, Paul Krugman, David Andolfatto, Brad DeLong, David Beckworth, and Steve Williamson at their respective blogs, and possibly others I have not seen yet.)

As you know, I am not too keen on "output gap" ideas as they are knocked around in the business press and in policy circles. I just do not think the output gap rhetoric matches up very well with the state of knowledge in the macroeconomics literature, either conceptually or empirically.

Neil Irwin at the Washington Post does an excellent job of telling the standard story concerning the output gap. I know you like this story, and you have a lot of company, because it dominates much of the discussion about the U.S. economy. I said this potential output calculation is basically an extrapolation of real GDP from 2007Q4 using growth rates from the years immediately preceding. Of course it is not, it is just ... statistically indistinguishable from an extrapolation of real GDP from 2007Q4 using growth rates from the years immediately preceding!

First, I want to restate my bubble idea in more geeky terms based in part on the basic story presented by Irwin. I know I am an army of one on this issue, but I think it is important to debate the output gap concept because it is having a huge impact on policy choices. And, I think my approach makes more sense given the very damaging housing bubble in the U.S. during the mid-2000s.

Second, as I am under no illusions that I can get you to come to reason on the fallacies behind the Irwin graph any time soon, I want to make a plea to at least use the available literature to define potential output appropriately for monetary policy purposes. As Basu and Fernald stress, we need a full DSGE model to be able to discuss the appropriate measure of the output gap for monetary policy. Fortunately, outstanding work by Mike Woodford at Columbia and co-authors has at least given us a benchmark model. In that work, the key gap concept is the difference between the sticky price and flexible price level of output, not the difference between actual output and a measure of trend output as in the Irwin graph.

The housing bubble in the 2000s

Here is a shorter and geekier version of the Chicago talk: If we look at Irwin's graph, actual output is essentially at CBO potential during 2005, 2006, and 2007. There is nothing about the CBO potential calculation that allows "bubble" levels of output. That is just not part of the analysis--it is off the radar screen. Potential in this picture is simply a projection based on a production function approach.

At the same time, we often say that these years were characterized by a bubble in housing. One way to interpret this is that fluctuations in real variables were driven by beliefs alone. We certainly have a very good candidate for what this widespread belief was--namely, "house prices never fall."

If households and businesses had ignored the house price developments as a sort of amusing side show, it would not have been so important. But our rhetoric about the decade suggests otherwise. Households consumed more through cash-out refinancing, developers built more, borrowing increased, Wall Street produced new financially-engineered products to feed the boom, and ancillary industries like transportation thrived. Output went up, and labor supply was higher than it otherwise would have been.

Rhetorically, this is consistent with what most analysts say happened. But we also have a large literature on so-called sunspot equilibria which tells us that fluctuations can be self-fulfilling (driven by beliefs alone) and consistent with rational expectations. According to that literature, the technology for the production of goods would not have to change at all, but the amount of output, consumption, labor supply and other real variables would fluctuate solely in response to the belief. These fluctuations lower welfare for risk-averse households. Potential output via a production function approach would then be sensibly described as that amount of output which would have been produced in the absence of the belief. I think it is plausible that such a line would be lower than the CBO potential line in Irwin's picture, and thus that the current output gap even by a production function metric would be smaller than the one in the picture.

So, what Irwin's picture is doing is taking all of the upside of the bubble and saying, in effect, "this is where the economy should be." But that peak was based on the widespread belief that "house prices never fall." We will not return to that situation unless the widespread belief returns. I am saying that the belief is not likely to return--house prices have fallen dramatically and people have been badly burned by the crash. So I am interpreting your admonitions on policy as saying, in effect, please reinflate the bubble. First, I am not sure it is possible, and second, that sounds like an awfully volatile future for the U.S., as future bubbles will burst once again.

This is admittedly a qualitative story, but much of the rhetoric about the U.S. economy during this period fits this description. So it is not that the bubble destroyed potential, instead it is that actual output was higher than properly-defined potential during the mid-2000s, and then it crashed back as the bubble burst.

The macroeconomic literature on sunspot equilibria is dense and filled with conditions under which such phenomena could occur. But I will say that one key condition keeps recurring: low real interest rates.

As I noted earlier, the Irwin description is the dominant view of the U.S. economy. But, as you and many others have stressed, we have not seen the bounce back toward potential that would be suggested by that picture. That is giving me pause, and frankly I think it is giving everyone who follows the U.S. economy pause. We owe it to ourselves to at least consider alternative possibilities.

Basu and Fernald

Ok, let's now forget about self-fulfilling beliefs and simply assume that whatever was going on in housing during the mid-2000s was more benign.

As Basu and Fernald discuss, "... few, if any, modern macroeconomic models would imply that, at business cycle frequencies, potential output is a smooth series." One possibility would be to use the leading monetary policy literature (e.g., Woodford [2003, Interest and Prices, Princeton University Press]) available to tell us what potential output should be. According to the New Keynesian literature, the relevant output gap is the distance between the actual level of output under sticky prices and the flexible price level of output. It is the flexible price level of output that represents the potential in the economy. The flexible price level of output would fluctuate continuously in response to shocks hitting the economy. This gap has been estimated in the literature, and I think it is fair to say that the concept is quite different from what is in the traditional story as told by Irwin. There are also unemployment versions of this (that is, NK models with search unemployment included)--I might recommend papers by Mark Gertler at NYU and co-authors. But the concept is the same.

So, if you do not believe my sunspot story, then fine, we can assume that housing price appreciation during the 2000s did not importantly affect output and other key macroeconomic variables. But let's at least use the appropriate definition of the output gap according to the available NK literature.

I know this last point was not in my talk in Chicago, but it is a theme that I often return to because I think is important in the output gap context.

Thanks again for the comments. As always, I find them stimulating and insightful. I think ongoing debate concerning these difficult issues is important.

This discussion of recent trends in economic mobility is from Bhashkar Mazumder, a senior economist at the Federal reserve Bank of Chicago. The results, which are based, in part, on his research in this area, suggest "cause for concern":

Is intergenerational economic mobility lower now than in the past?, Chicago Fed Letter: In the wake of the Great Recession and the growth in income inequality over recent decades in the United States, the degree of economic mobility over generations has become an increasingly salient issue. A recent New York Times article highlighted the growing evidence showing that intergenerational economic mobility appears to be lower in the United States than in other advanced countries.1 President Obama and Republican presidential candidates have also referenced intergenerational mobility as being an issue of concern.2 One dimension of this issue that is not well understood, however, is whether intergenerational mobility has been changing over time and whether the prospects for mobility have been hampered for children growing up in families that have been hard hit by the recent economic downturn.

This Chicago Fed Letter discusses some of the research on trends in intergenerational mobility. I begin by describing how intergenerational economic mobility is commonly measured and show that, conceptually, it is a “backwards-looking” measure that describes the mobility experience of individuals born decades earlier. I then discuss two distinct approaches I have used in previous studies to study long-term trends in intergenerational mobility. After staying relatively stable for several decades, intergenerational mobility appears to have declined sharply at some point between 1980 and 1990, a period in which both income inequality and the economic returns to education rose sharply. This finding is also consistent with theoretical models of intergenerational mobility that emphasize the role of human capital formation. There is fairly consistent evidence that intergenerational mobility has stayed roughly constant since 1990 but remains below the rates of mobility experienced from 1950 to 1980.

Although we cannot say with any certainty how much mobility today’s children will experience over the coming decades, recent research suggests cause for concern. The gap in children’s academic performance between high- and low-income families has widened significantly over the last few decades. If this trend persists, it would point to reduced intergenerational economic mobility going forward. ...

Monday, February 13, 2012

Dani Rodrik argues that the demise of the nation state is not as close as you may have been led to believe:

The Nation-State Reborn, by Dani Rodrik, Commentary, Project Syndicate: One of our era’s foundational myths is that globalization has condemned the nation-state to irrelevance. The revolution in transport and communications, we hear, has vaporized borders and shrunk the world. New modes of governance ... are ... supplanting national lawmakers. Domestic policymakers, it is said, are largely powerless in the face of global markets.

The global financial crisis has shattered this myth. Who bailed out the banks,... engaged in fiscal stimulus, and provided the safety nets for the unemployed...? Who is re-writing the rules on financial-market ... regulation to prevent another occurrence? ... The answer is always the same: national governments. The G-20, the International Monetary Fund, and the Basel Committee on Banking Supervision have been largely sideshows. ...

Yet even as the nation-state survives, its reputation lies in tatters. ... First, there is the critique by economists who view governments as an impediment to the freer flow of goods, capital, and people around the world. Prevent domestic policymakers from intervening with their regulations and barriers, they say, and global markets will take care of themselves,... creating a more integrated and efficient world economy. But who will provide the market’s rules and regulations, if not nation-states? Laissez-faire is a recipe for more financial crises and greater political backlash. ...

Second, there are cosmopolitan ethicists who decry the artificiality of national borders. ... It is unclear how much of this is wishful thinking and how much is based on real shifts in identities and attachments. Survey evidence shows that attachment to the nation-state remains quite strong. ...

The trouble is that we are still in the grasp of the myth of the nation-state’s decline. Political leaders plead impotence, intellectuals dream up implausible global-governance schemes, and the losers increasingly blame immigrants or imports. ...

To be sure,... we should not entirely dismiss the likelihood that a true global consciousness will develop in the future, along with transnational political communities.

But today’s challenges cannot be met by institutions that do not (yet) exist. For now, people still must turn for solutions to their national governments, which remain the best hope for collective action. The nation-state may be a relic bequeathed to us by the French Revolution, but it is all that we have.

As Molly Ball of The Atlantic pointed out, Mr. Romney “described conservatism as if it were a disease.” ... That’s clearly not what Mr. Romney meant to convey. Yet if you look at the race for the GOP presidential nomination, you have to wonder whether it was a Freudian slip. For something has clearly gone very wrong with modern American conservatism.

Start with Rick Santorum ..., best known for 2003 remarks about homosexuality, incest and bestiality. But his strangeness runs deeper than that. ... Mr. Santorum made a point of defending the medieval Crusades against the “American left who hates Christendom”..., he has also declared that climate change is a hoax ... on the part of “the left” to provide “an excuse for more government control of your life.” You may say that such conspiracy-theorizing is hardly unique to Mr. Santorum, but that’s the point: tinfoil hats have become a common, if not mandatory, GOP fashion accessory.

Then there’s Ron Paul, who came in a strong second in Maine’s caucuses despite ... the racist (and conspiracy-minded) newsletters published under his name ... and his declarations that both the Civil War and the Civil Rights Act were mistakes. ...

Finally, there’s Mr. Romney... The truth, of course, is that he was not a “severely conservative” governor. ... So he can’t run on his record in office. ... Instead, his stump speeches rely almost entirely on fantasies and fabrications designed to appeal to the delusions of the conservative base. ...

How did American conservatism end up so detached from, indeed at odds with, facts and rationality? ...

My short answer is that the long-running con game of economic conservatives and the wealthy supporters they serve finally went bad. For decades the GOP has won elections by appealing to social and racial divisions, only to turn after each victory to deregulation and tax cuts for the wealthy — a process that reached its epitome when George W. Bush won re-election by posing as America’s defender against gay married terrorists, then announced that he had a mandate to privatize Social Security.

Over time, however, this strategy created a base that really believed in all the hokum — and now the party elite has lost control.

The point is that today’s dismal GOP field ... is no accident. Economic conservatives played a cynical game, and now they’re facing the blowback, a party that suffers from “severe” conservatism in the worst way. ...

Bullard was moving in this direction last month, but he really didn't outline his thinking. Now he has, and sadly revealed that there really wasn't that much thinking at all. Bullard attempts to argue against the "output gap" framework shaping monetary policy:

The recent recession has given rise to the idea that there is a very large “output gap” in the U.S. The story is that this large output gap is “keeping inflation at bay” and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States. I want to now turn to argue that the large output gap view may be conceptually inappropriate in the current situation.

First off, Bullard just flat out does not understand the definition of potential output:

The key to the large output gap story is the use of the fourth quarter of 2007 as a benchmark for where we expect the economy to be today. The idea is to take that level of real output, assume the real GDP growth rate that prevailed in the years prior to 2007, and project out where the “potential” output of the U.S. should be.

Estimates of potential GDP are not simple extrapolations of actual GDP from the peak of the last business cycles. They are estimates of the maximum sustainable output given fully employed resources. The backbone of the CBO's estimates is a Solow Growth model. So I don't think that Noah Smith is quite accurate when he says:

So, basically, what we have here is Bullard saying that the neoclassical (Solow) growth model - and all models like it - are wrong. He's saying that a change in asset prices can cause a permanent change in the equilibrium capital/labor ratio.

Bullard can't be saying the Solow growth model is wrong because he doesn't realize that such a model is the basis for the estimates he is criticizing.

Second, as as already been widely circulated, Bullard then attempts to use a demand side shock to justify his contention that estimates of potential GDP are too high:

A better interpretation of the behavior of U.S. real GDP over the last five years may be that the economy was disrupted by a permanent, one-time shock to wealth. In particular, the perceived value of U.S. real estate fell substantially with the 30 percent decline in housing prices after 2006. This shaved trillions of dollars off of the wealth of the nation. Since housing prices are not expected to rebound to the previous peak anytime soon, that wealth is simply gone for now. This has lowered consumption and output, and lower levels of production have caused a significant disruption in U.S. labor markets.

Follow the links above to Sumner and Krugman for rebuttals to this line of thought. Brad DeLong tries to give Bullard a little help by noting that the bubble may have influenced labor force participation rates, but DeLong also notes these are at best small and were not Bullard's argument in any event. Bullard's chain of thinking is not so sophisticated. Sure, you can argue that he does have labor in the equation:

I mentioned that a wealth shock significantly upsets labor market relationships. This is because output declines, so less labor is required. It takes a long time for those displaced by the shock to find new working relationships.

But again, this is a demand side story. If output were higher, then so too would be the demand for labor. Simply put, Bullard simply moves from the wealth effect to a drop in consumption, and assume that drop in consumption represents a shock to potential GDP, inexplicably confusing demand and supply.

I don't think there is much of a viable defense of Bullard - he gets both the empirics and the theory wrong. He doesn't attempt to define a change in the factors of production that would lead to a shift in potential GDP, nor does he attempt to argue that the estimates of potential GDP are wrong, either from a time series trend/cycle decomposition framework or a CBO Solow growth framework. But note that it gets worse when he extends his faulty logic to policy:

I have argued that the large output gap view may be keeping us all prisoner—tethering our expectations for output, in effect, to the collapsed bubble in housing. It is setting a very high bar for the U.S. economy, one that may not be appropriate given the nature of the shock that the economy has suffered. Importantly, it may influence the FOMC’s near-zero rate policy far into the future, since output is continually viewed as falling short of the high-bar benchmark.

But the near-zero rate policy has its own costs. If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy. But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.

In particular, the lengthy near-zero rate policy punishes savers in the economy...

According to Bullard, monetary policy is stuck at near zero-interest rates because of overestimation of the output gap, and as a consequence savers are suffering. First, if the output gap is smaller than estimated, or the economy outperforms, the Fed can change course and raise interest rates. They have only issued a forecast, not a commitment.

And, second, I have been through this before - while I am very sympathetic to the plight of savers, Bullard does not consider that the Fed is merely following the lead of the economy. Another way to think about the situation is that the supply of savings and the demand for investment currently would clear only at a negative interest rate - see Paul Krugman here. Also note the excess of private saving over private investment, which is exactly what you would expect if the market clearing interest rate was below the zero bound:

If the Fed's zero-interest rate policy is leading to fundamental distortions in the economy, it is because the Fed is not taking seriously enough the need to lift the economy away from the zero-bound. And I don't know that they can push the economy off the zero-bound if they limit their policy options with a strict two percent inflation target.

Bullard also shows significant sympathy for the notion that Fed policy is a net drag on activity:

These low rates of return mean that some of the consumption that would otherwise be enjoyed by the older, asset-holding households has been pared back. In principle, the low real interest rates should encourage younger generations to borrow against their future income prospects and consume more today. However, this demographic group faces high unemployment rates and tighter borrowing constraints, which may limit its ability and willingness to leverage up to finance consumption. Consequently, the consumption of the older generations may be damaged by the low real interest rates without any countervailing increase in consumption by other households in the economy. In this sense, the policy could be counterproductive.

If you truly believe this argument, then you must believe that a higher Federal Funds rate will have a net positive impact on output. But I have yet to see a convincing argument as to why this should be so - raising rates will only make matters worse if the market clearing rate is already negative. Note also that the ECB's last two forays into the realm of tighter policy have not been particularly successful, to say the least.

Bottom Line: Bullard really went down an intellectual dead end last week. He criticized the focus on potential output, but revealed that he doesn't really understand the concept of potential output either empirically or theoretically. He then compounds that error by arguing against the current stance of monetary policy, but fails to provide an alternative policy path. And the presumed policy path, tighter policy, looks likely to only worsen the distortions he argues the Fed is creating. I just don't see where Bullard thinks he is taking us.

Sunday, February 12, 2012

Tyler Cowen says there's no need to break up big banks or impose lots and lots of regulations to ensure they can't take excessive risks with other people's money, making shareholders responsible for bank losses would fix the problems:

So the logic of cutting down huge institutions could mean splitting the largest ones into several pieces. Yet banks do not always come in easily divisible parts. Such a move could amount to eradicating the largest banks rather than splitting them up — and eradication is both politically unlikely and potentially disastrous for the economy. In short, if the resulting parts of a divided bank cannot turn a profit, the split-up may prompt the very bailout it was trying to avoid.

Another fear is that American money market operations would move to larger foreign banks, which would have a newly found competitive advantage. ...

There is still another problem. The more a bank is legally limited in terms of easily measurable size, the more it may resort to off-balance-sheet activities to make up the difference. “Breaking up big banks” may really mean making these less-transparent bank activities much more important to a bank’s fate.

Maybe tough new rules for off-balance-sheet activities could limit this problem, but the overall history of financial regulation belies that view. ...

There is a better alternative: expanding the liability for major financial institutions. If a shareholder invests a dollar in a big bank, why not make that shareholder liable for the first $1.50 — or more — of losses as insolvency approaches? In essence, we would be making the shareholders liable for the costs that bank failures impose on society, and making the banks sort out the right mixes of activities and risks. ...

This proposal would shrink the financial sector, while avoiding excess regulatory micromanagement of bank activities. But it could still be combined with other regulations, like limits on leverage, if deemed appropriate or necessary.

Unlike the “big is bad” view, this proposal would penalize failing banks rather than safe, successful ones that happen to be large. ...

We need to resist vengeful or “feel good” options for financial reform and embrace those that will really work.

Some notes: First, there's an implicit assumption in this article about the minimum efficient scale for a bank. Tyler worries that breaking up banks will result in less efficient banking operations (i.e. higher cost) causing the smaller banks to fail altogether, or be less competitive with foreign banks.

However, I have not seen convincing evidence that banks need to be as large as they are for efficiency reasons (here's some evidence, but as I noted, I am not convinced by it). I am not advocating a per se rule here -- we shouldn't break them up just because. But if there's evidence that the size leads to undue political or economic power that is being exploited in the banks' favor, and if mega-mega-size is not necessary for efficiency, then there is definitely a reason to break them into smaller pieces. From my perspective, there is quite a bit of evidence that these banks have far too much political influence, and I think a case can also be made that it's unhealthy for the economy to have firms with such a large market share in particular segments of financial markets.

So I think that, absent of strong evidence that there actually are economic efficiencies associated with size (in which case they ought to be treated more like a regulated monopoly than a competitive marketplace), and the evidence that these banks are highly influential politically -- to the point where regulatory capture is more than a passing worry -- we should break these banks into pieces that are closer to the "minimum efficient scale" for financial institutions. I think the minimum is much smaller than current size, but once again, if that's not true then we need to treat these banks more natural monopolies (or natural bilateral monopolies, trilateral monopolies, or too small of a number to be competitive industries).

But we shouldn't fool ourselves into thinking that breaking up big banks into smaller pieces will necessarily make the financial system more stable. We had bank runs and financial meltdowns in eras where there were predominately small banks, think of the Great Depression for example. That's because it's the interconnectedness of banks that causes the problems, and smaller banks can be just as interconnected and hence just as vulnerable to a systemic shock as large banks. Perhaps there's a bit more diversification in larger banks that offers some protection, but the evidence is not strong on this point and big banks appear to be just as vulnerable as small banks to systemic troubles (and vice versa).

The stability of the system has more to do with regulatory restrictions, e.g. controlling the risks that shadow banks can take, or with economic mechanisms of the type Tyler is calling for that get the incentives for financial firms to take risk correct, than it does the size of institutions. I am not as confident as Tyler is that his scheme will work -- I am more inclined to pursue the regulatory route -- but in any case the problem of how to enhance the stability of the financial system is not about the size of banks as much as it's about interconnectedness and the degree to which financial firms can take risks without facing the full consequences of their decisions.

One final note: It seems to me that given the lack of transparency in the financial system -- the inability of investors to monitor the risks that banks are taking with the money they invest, and the lack of solutions such as reliable ratings agencies that help to overcome this informational disadvantage -- making investors liable for even more than they actually invest in a bank would kill the incentive for average or even above average investors to put money into this industry (and the ability of shareholders to monitor corporations even when informational problems are much less severe appears to be problematic). If finance and large banks are as critical to the economy as Tyler claims, does he really want to take the chance of causing investors to shy away from this industry to the point where their willingness to invest falls short of what is optimal given full knowledge of the risks they face? On this score, I think the traditional banking sector approach of providing some form of depositor guarantee coupled with limits on risks that banks can take and insurance premiums to cover depositor losses and limit moral hazard is a better approach. There are difficulties with providing depositor guarantees in the shadow banking system, but as Morgan Ricks argues, there are ways to over come this problem (Gorton and Metrick also have a proposal involving improving the collateral banks hold as insurance against depositor losses).

But whatever we do, we need to get on with it. Despite the Dodd-Frank financial reform bill and its directive to address this issue, the problem of bank runs in the shadow system -- a key factor in the financial sector collapse -- has not yet been solved. Work on this is underway, and new reulations are in the works, but for now the problem has not yet been resolved.

Admittedly, this is a small number compared with overall private-sector job gains of 3.7 million during the same period, but it reverses the trend of declining manufacturing employment since the late 1990s.

And promising signs are emerging that American companies are shifting some manufacturing production and employment back to the United States. Policies to strengthen the competitiveness of the United States as a location for manufacturing can strengthen these nascent developments.

Though there are economists who do not share my heretical view, I believe that a strong manufacturing sector matters ... for several reasons. First, economists agree that the United States must rebalance growth away from consumption and imports financed by foreign borrowing toward exports. ...

Third, manufacturing matters because of its substantial and disproportionate role in innovation. ...

In his State of the Union speech, President Obama proposed several additional changes in business taxes to discourage the outsourcing of manufacturing jobs and to encourage their creation in the United States.

A significant reduction in the corporate tax rate in the United States, which is the second highest among the developed countries, would be a much more powerful incentive to encourage American manufacturing production than these changes. Nor is it likely that they would have much effect on American manufacturing employment, because outsourcing has not been the major cause of manufacturing job losses. ...

The remarkable divergence between manufacturing output and employment reflects strong labor productivity growth, driven by labor-saving technological progress. This trend is likely to persist independent of changes in corporate taxation.

The other policies President Obama is promoting to support manufacturing — measures to increase high-school graduation rates; work-force training programs at community colleges; more support for basic research, infrastructure investment, and scientific, engineering and technical education; and immigration reform — would benefit not just manufacturing but the entire economy.

There is widespread support for such policies among economists, whatever their view of the role of manufacturing.

Saturday, February 11, 2012

David Altig says he isn't too worried about inventory accumulation in the fourth quarter of last year translating into slower growth in the first part of this year (I added some general comments on the recovery at the end):

Reading the bump in inventories, by David Altig: Yesterday's wholesale trade report, with its positive surprise in December inventory accumulation, has estimates of fourth quarter gross domestic product (GDP) on the rise again.For the advance GDP release, the U.S. Bureau of Economic Analysis assumed that the book value of merchant wholesale inventories rose by $17 billion (at a seasonally adjusted annual rate, or SAAR) in December. The wholesale trade report suggests the book value instead may have risen by $56 billion SAAR. Our own calculations suggest fourth quarter GDP may be revised up from 2.8 percent to around 3.1 percent.A piece of that revision comes from positive sales activity, which would appear to be an unambiguous plus.

The inventory piece is trickier. Forecasters have a tendency—because the statistics have a tendency—to take a larger-than-expected inventory buildup in one quarter out of growth estimates for the next quarter. The implication in present tense is, of course, that 2012 may start out on the slow side as the fourth quarter inventory swell is run off.

That's not how we see it. Our current read is that it is better to think of the fourth quarter inventory buildup as a payback from a decumulation in the third quarter. Here's a look at overall inventory changes over the recent past, broken down into their various industrial components:

If you look hard, you will see that, though the fourth quarter inventory rise was broad-based, the third to fourth quarter change in wholesale inventories was particularly notable. In fact, the wholesale inventory picture in the back half of 2011 was dominated by a fairly large decumulation of nondurable goods inventories in the third quarter, a decline that was reversed in the last three months of the year:

So, consider two stories that might frame thinking about the role of inventories in GDP growth in the first quarter or first half of this year. One story is inventory-inflated growth in the fourth quarter of 2011, to be followed by payback in the form of a drag on production in the first quarter (or so) of 2012. Another story is that the drag actually emerged in the third quarter of last year, providing a little extra juice in the fourth quarter, with no particular consequences for the current-year growth trajectory.

Right now, it looks to us like the latter story might be the right one. Of course, that doesn't mean there aren't significant risks to the outlook for domestic production, and hence inventories. For instance, although today's report on international trade in December was relatively benign in terms of fourth quarter GDP revisions, it did show a substantial further weakening in exports to the euro zone. Weaker demand from Europe will weigh on U.S. export growth. The big unknown is how weak that demand will get.

For me the big uncertainties right now are the pace of the recovery (will it remain plodding and take years or will we see an accelerattion in activity?), how much trouble we'll encounter along the way -- it's unlikely the return to full employment will come without setbacks of some sort -- whether the setbacks will be temporary blips or longer lived problems, and how policymakers react when the inevitable trouble hits.

Policymakers will have a lot to do with how those uncertainites play out. Monetary and fiscal authorities could push a faster recovery with the appropriate policies, but while the Fed seems more inclined in this direction than fiscal authorities, I don't expect anything substantial from either. More likely is that policies will be reversed before the economy is ready for it. If monetary and fiscal authorities withdraw support for the economy too soon through austerity measures designed to balance the budget and interest rate increases out of fear of inflation, the recovery will be delayed. In addition, there will be a tendency for policymakers to minimize any trouble we encounter and continue with the assumption that greener pastures are just around the corner. This avoids difficult policy decisions, but misplaced optimism of the type we've seen throughout the crisis puts policymakers behind the curve when we encounter difficulties that are persistant rather than blips, and the delayed policy response hampers our recovery efforts. The risks of too much policy and too little are not symmetric. If policymakers make a mistake, it ought to be in the direction of too much support for the economy for too long rather than too little support that ends early. The reality is that policy support has been too little all along, and that's unlikely to change, but that doesn't mean it also has to be reversed too soon as well.

Friday, February 10, 2012

Romney’s severely conservative budget promises, by Ezra Klein: In his speech to CPAC, Mitt Romney repeated a promise that he’s delivered repeatedly on the campaign trail. “Without raising taxes or sacrificing America’s critical defense superiority, I will finally balance the budget.” That sounds pretty good. It sounds really good, in fact. And then you look at the numbers...

Romney ... has offered enough detail that we can estimate the cuts required to meet his targets. In that spirit, the Center on Budget and Policy Priorities tried to run the numbers on Romney’s proposals. The results were so outlandish that they actually ran them two ways to make Romney look better.

In the first scenario, Romney follows through on his promise to balance the budget and cuts spending to 17 percent of GDP [as promised]. If you assume Romney is balancing the budget by 2021 — the end of his second term — that requires cutting expected spending on every domestic program, including Social Security and Medicare, by 36.4 percent. If Social Security is spared, as Romney has suggested it will be for the next 10 years, that rises to 53.4 percent.

In the second scenario, Romney ignores his promise to balance the budget and simply tries to cap spending at 20 percent of GDP [as promised]. Then, the required cuts to domestic programs are only 23.5 percent. And, if Social Security is spared, 34.5 percent. This is the scenario Romney tends to reference in his speeches...

Put aside whether you consider cuts of this magnitude desirable. Romney has not put forward any specific plans under which they would be achievable. And that’s for good reason:... If you assume the cuts are distributed equally across all domestic spending programs, Romney’s numbers imply cutting more than $500 billion from food stamps and related programs for the poorest Americans, cutting $2.3 trillion from Social Security, cutting $174 billion from veteran’s benefits and so forth.

These cuts are so deep in part because they are paying for trillions of dollars in relatively regressive tax cuts. So he’s not simply proposing to cut spending. He’s proposing to transfer resources from those who rely on government programs — namely, the poor and seniors — to those who will benefit from his tax cuts. ...

In his speech to CPAC, Romney criticized “those who say you can’t talk straight to the American people on these key issues and still win an election.” ... So far, Romney has been straight about how much he would like the government to spend. But is he ready to be straight about what he will cut?

The claim from conservatives that collapsing middle class family values is responsible for rising inequality diverts attention from the true cause of stagnating middle class incomes:

Money and Morals, by Paul Krugman, Commentary, NY Times: Lately inequality has re-entered the national conversation. Occupy Wall Street gave the issue visibility, while the Congressional Budget Office supplied hard data on the widening income gap. And the myth of a classless society has been exposed: Among rich countries, America stands out as the place where economic and social status is most likely to be inherited.

So you knew what was going to happen next. Suddenly, conservatives are telling us that it’s not really about money; it’s about morals. Never mind wage stagnation and all that, the real problem is the collapse of working-class family values, which is somehow the fault of liberals.

But is it really all about morals? No, it’s mainly about money.

To be fair, the new book at the heart of the conservative pushback, Charles Murray’s “Coming Apart: The State of White America, 1960-2010,” does highlight some striking trends. Among white Americans with a high school education or less, marriage rates and male labor force participation are down, while births out of wedlock are up. Clearly,... something is ... happening to the traditional working-class family. The question is what. And it is, frankly, amazing how quickly and blithely conservatives dismiss the seemingly obvious answer: A drastic reduction in the work opportunities available to less-educated men. ...

For lower-education working men,... entry-level wages ... have fallen 23 percent since 1973. Meanwhile, employment benefits have collapsed. ... So we have become a society in which less-educated men have great difficulty finding jobs with decent wages and good benefits. Yet somehow we’re supposed to be surprised that such men have become less likely to participate in the work force or get married, and conclude that there must have been some mysterious moral collapse caused by snooty liberals. And Mr. Murray also tells us that working-class marriages, when they do happen, have become less happy; strange to say, money problems will do that.

One more thought: The real winner in this controversy is the distinguished sociologist William Julius Wilson.

Back in 1996,... Mr. Wilson ... argued that much of the social disruption among African-Americans popularly attributed to collapsing values was actually caused by a lack of blue-collar jobs in urban areas. If he was right, you would expect something similar to happen if another social group — say, working-class whites — experienced a comparable loss of economic opportunity. And so it has.

So we should reject the attempt to divert the national conversation away from soaring inequality toward the alleged moral failings of those Americans being left behind. ...

It seems to me that New Keynesian macro consists (as here) in writing models with optimizing agents which behave the way old Keynesian models behave. I ask why not cut out the middle man?

The model as written has implications other than that there is something like an IS curve. As you note, the true expected value (that is rationally expected) of future GDP affects current GDP. Also the real interest rate affects the rate of growth of consumption.

The problem is that, to the extent new Keynessian models differ from old Keynesian models, the data are not kind to the new models. ...

The newness is all about intertemporal optimization without liquidity constraints. It clearly gives false implications. So the model is modified so that it acts just like an old Keynesian model. How is this a worthwhile activity ?

Notably, the micro foundations are not justified on the assumption that people really intertemporally optimize with rational expectations. ... There is no reason to believe that the definitely false assumptions that new Keynesians like to make are better than any other definitely false assumptions. ...

What, of any value, have macroeconomists added to Keynes? ...

As Robert notes, one big difference between the Old and New Keynesian models is the way in which expectations are treated. The older models do not incorporate expectations, e.g. expected future monetary and fiscal policy, in an acceptable way. When expectations of current and future events are unimportant, the distinction between the Old and New models is not that large. But when expectations do matter -- as I believe they often do -- then the older models can miss important feedback effects.

For example (which some will recognize as a version of the Lucas critique, something Robert refers to indirectly in a part of his post that I omitted), suppose that you take a survey with a hidden camera and discover that there are 10 cars per hour speeding on a given section of road. Thus, you figure, at $200 per ticket the city will make $2,000 per hour (gross) by stationing traffic police along that part of the road.

However, after stationing traffic police at the location, the actual number of tickets that are written is far short of projections. Why is that? It's because people will call/tweet/text their friends and family and warn them -- don't speed today, they are giving tickets. People who travel the route many times a day will notice the officers with radar guns and, if they avoid detection the first time -- or even, I suppose, if they don't -- the will be careful on subsequent passes. Even if people are mostly surprised the first day and revenues are near projections, on day 2 people will expect officers at those locations and be more careful. And if not on day 2, by day 3 they will have surely learned.

And that is the key. The policy works only so long as it is a surprise. If people know about the policy -- if they expect it in advance -- then they will be careful to avoid getting a ticket. If every single person expects the policy, if they know the officers will be there, then there shouldn't be any tickets at all if people behave rationally and there is no "stickiness" in the model that prevents them from taking evasive action.

It's no different with macroeconomic policy. If the government puts a policy in place, e.g. new taxes, then people will do their best to avoid having it harm them. If they can take cost effective actions to avoid the new taxes, then they will. A failure to account for this can lead to big mistakes in forecasts of the impact of new taxes on tax revenue in the same way that a failure to account for the fact that when people know that officers are watching they change their behavior causes revenue projections to be wrong.

Old Keynesian models do not account for these expectation effects satisfactorily, and that's one of the reasons I think the newer models provide a stronger framework to evaluate the effects of policy.

[This is evident in this post where the NK IS curve (which is really an Euler equation -- i.e. in essence a first order condition in a maximization problem) contains the term EtYt+1 while the standard IS curve does not.]

But let me be clear about what I mean by a New Keynesian model. For me it is nothing more than a dynamic, stochastic general equilibrium model with some type of friction tacked onto to it (or arising endogenously, which is more desirable though harder theoretically), and some sort of expectations/learning mechanism embedded within it.

I am not at all convinced, however, that the type of friction that is used in garden variety versions of the NK model -- the Calvo price stickiness mechanism -- is the correct type of friction to characterize the recession we have just experienced (nor do I have much faith in simulations of, say, monetary or fiscal policy that rely upon this assumption to generate policy effects). The type of transmission mechanism that is operable in this model, price stickiness that causes relative prices to go awry, which in turn causes resources to be misdirected, does not seem to me to capture the essence of the breakdown in financial intermediation at the heart of the financial collapse (though stickiness in housing prices and perhaps wages may help to explain the pace of the recovery, but even then it is nowhere near the full story). I think a friction/information problem/market failure of some sort is involved, but the connections between the real and financial sectors that is needed to explain what we have just experienced is not present in these models. There are versions of these models that take steps in this direction, and work is going on right now to try to solve this problem and connect the real economy to the financial sector in a meaningful way -- some of which is making inroads -- but I am just not convinced that the models we have right now properly capture the transmission mechanism for shocks of the type we have just experienced. So there is definitely more work to be done. But I don't think we solve the problem by going back to older constructions.

(However, as I've argued before, in the meantime there are times when the old fashioned IS-LM model delivers better answers than modern models, or at least serves as a better rough guide. This is, in part, because the older models were built to answer the kinds of questions we confront today, questions that arose out of the great Depression, while the NK model was built to explain milder fluctuations, the type we saw in the Great Moderation. These milder fluctuations may very well may be driven by price stickiness of the type characterized by Calvo-type models, but Calvo models don't do so well when confronted with a financial meltdown. But if you are going to take guidance from the older models it is essential that you understand the limitations of the model -- this should not to be done without a thorough knowledge of the pitfalls involved and where they can and cannot be avoided -- the kind of knowledge someone like Paul Krugman surely has at hand.)

I believe, then, that the use of dynamic, stochastic, general equilibrium structures that incorporate expectations in a defensible way is the way to go. Thus, there is no need to discard the set of tools that we have. However, though we have the tools, for the most part anyway, we failed to ask the right questions. This is partly a technical issue. We use representative agent models to set aside the difficult problems involved with aggregation across diverse agents, but models where there are connections between the real and financial sectors often require the representative agent structure to be set aside. But setting this aside means confronting the difficult technical problems directly, and this is an area where we are frantically developing tools right now so that we can overcome this limitation. But in the past it was easier to simply assume a single, representative agent and not deal with with it at all. Handling it in this was wasn't thought to be a big problem since our own overconfidence in ourselves and our abilities led us to believe that we had solved the problem of large, long-lived depressions driven by financial meltdowns. Why go to all the trouble of developing the technical apparatus to ask what if questions about financial meltdowns if there was little chance of this happening? It just wasn't worth the trouble -- then anyway -- now we (hopefully) know better.

Let me also address, briefly, Robert's concern about the rationality assumption. As someone in a department who specializes in learning models (and we are in the process of hiring a great senior faculty member to augment that expertise), I am not going to defend the rationality assumption as it is usually made in DSGE models. But that doesn't mean that plugging a better expectation formation mechanism into these models, along with the proper frictions and expectational feedback mechanisms, can't produce reasonable results.

There is much more to be said about all of this, but this is running fairly long already, so let me just close by noting that when I say I support the newer models over the older, I don't mean to say that the new models have gotten us anywhere near where we need to go. I think they are pointing in the right direction -- though I wouldn't mind if some theorists backed up, and then rebuilt things along a different path so that we'd have more alternatives to test against each other, and more chances to stumble toward better understanding f how the macroeconomy works -- but there is no doubt that there is considerable work yet to be done.

Forty years ago today, U.S. President Richard Nixon closed the gold window and ushered in, for the first time in human history, a global system of unconstrained paper money under full control of the state.

Now, with that title, that lede, and Schlichter’s very stern opinions about paper money, you’d think that the paper money era began right then, forty years ago. But as Schlichter himself says in his very next sentence,

It is not that prior to August 15, 1971, there was a gold standard. Far from it. Most countries had severed any direct link between their currencies and gold many years earlier.

Right..., the monetary thing that was not, per Schlichter, a gold standard – the monetary thing that happened to go along with decades of global growth and prosperity, the monetary thing that goes wholly unmentioned in the op-ed, was the Bretton Woods system.

The whole point of Bretton Woods was to get away from the gold standard. Indeed, that was practically the whole point of the Roosevelt administration’s monetary policy. Which is unsurprising, because adherence to the gold standard exacerbated the Great Depression, as Federal Reserve officials viewed keeping gold in vaults a more important goal than adding jobs to the economy. ...

The best monetary arrangement, some of Roosevelt’s Treasury officials figured in 1934, was to fix exchange rates – that would give you one advantage of gold, which is to say that international contracts would always be predictable, so trade would be easy – but you would also reserve the right to move rates in case of need. Best of both worlds... Hence Bretton Woods and the adjustable peg – currencies convertible to one another at fixed, but (at need) adjustable, rates.

The dollar was off gold for domestic purposes – there were no circulating gold coins after 19331 nor was paper money redeemable in gold – but the dollar remained convertible at $35/oz for international claims. The IMF existed to stabilize exchange rates among member currencies.

Wait, you say, isn’t that a gold standard? No, in thunder, wrote Bretton Woods’s architects – read what Harry Dexter White said: under a gold standard you’re interested only in price stability – “the sole purpose of the Fund might be misunderstood to be stability of exchange rates.” That’s actually not how Bretton Woods worked. Take a look at the IMF charter – stability of prices is subordinate to “high levels of employment and real income” – stability of currency was “a means of achieving the objectives” of jobs and high wages.

The Roosevelt administration had to fight like tigers for the IMF against bankers who hated it for just this reason – the bankers wanted debts paid off first, without inflation, and they didn’t care much about jobs or wages. They wanted “the hard, patient labor of reestablishing the economic soundness of participating countries, balancing of budgets … checking inflationary influences” – what we now call “austerity”.

FDR’s Treasury said no, we need jobs, to make sure the Depression doesn’t come back, see; then we will worry about balanced budgets and stability.

It was those guys – the Roosevelt Treasury – who won, and their system – and not the gold standard – that prevailed until Tricky Dick’s time.

So why does Schlichter portray a choice between the current policy and the gold standard, when he knows there was an intermediate and evidently effective system? In fairness, op-eds are very difficult to do in any responsible way, and maybe he talks about Bretton Woods in his book. But he didn’t on Start the Week, either.

Simon Johnson wonders why we are so stingy when people are having trouble through no fault of their own:

Mean-Spirited, Bad Economics, by Simon Johnson, The Baseline Scenario: The principle behind unemployment insurance is simple. Since the 1930s, employers ... have paid insurance premiums ... to the government. If people are laid off through no fault of their own, they can claim this insurance – just like you file a claim on your homeowner’s or renter’s policy if your home burns down.

Fire insurance is mostly sold by the private sector; unemployment insurance is “sold” by the government – because the private sector never performed this role adequately. The original legislative intent, reaffirmed over the years, is clear: Help people to help themselves in the face of shocks beyond their control.

But the severity and depth of our current recession raise an issue on a scale that we have literally not had to confront since the 1930s. What should we do when large numbers of people run out of standard unemployment benefits ... but still cannot find a job? At the moment, the federal government steps in to provide extended benefits.

In negotiations currently under way, House Republicans propose to cut back dramatically on these benefits, asserting that this will push people back to work and speed the recovery. Does this make sense, or is it bad economics, as well as being mean-spirited? ...

Why would anyone now seek to punish these people when they seek work but cannot get it? ... Extended unemployment benefit provides on average about $300 a week – ...only about 70 percent of the poverty level for a family of four. If you strip even this money from people who remain out of work through no fault of their own, you will push more individuals and families onto the streets and into shelters. The cost of providing those fall-back services is very high – and much higher than providing unemployment benefits.

How does it help any economic recovery when the people who lose jobs cannot even afford to buy basic goods and services – enough to keep their family afloat? ...

The recent attempt to portray the unemployed as lazy, TV watching, video game playing, frauds living off the benevolence of the government when they could be working is part of the effort of those who have managed to do well even though we've had a recession to avoid paying to help those who have been less fortunate. We will always be able to find people doing their best to take advantage of just about any program that helps people, but making a big deal out of those exceptions does not change the fact that the vast majority of the unemployed are just like the rest of us, just not quite as lucky. Whre's our compassion?

But how, exactly, a tax on financial transactions would help to cure Europe’s ills is unclear. According to the European Commission’s own estimates, it would raise only about €50 billion ($65.7 billion) a year, even if imposed throughout the European Union. This is a pittance compared to the eurozone’s debts and deficits, and would fall far short of funding Europe’s permanent rescue facility... Moreover, the Commission’s €50 billion estimate surely overstates the prospective receipts. ...

If the aim is to augment revenues, a Tobin tax is the wrong tool. Indeed, Tobin designed it to solve an entirely different problem: excessive volatility in currency markets. ...Tobin’s proposal sought to promote exchange-rate stability by preventing national currencies from coming under speculative attack. The irony, of course, is that eurozone members have no national currencies to attack. ...

Forgive my naiveté, but I have begun to think that politics rather than economics explains European leaders’ enthusiasm for a Tobin tax. Sarkozy can preempt a long-standing proposal of the Socialists in the run-up to this spring’s presidential election. By supporting Sarkozy, Merkel can get in return what she really wants: French support for stronger fiscal rules. And EU leaders can claim that the financial sector is being made to contribute to the costs of Europe’s financial cleanup. ...

Though no one can say for sure what Tobin would have thought of Europe’s crisis, his priority was always the pursuit of full employment. One suspects that he would have urged European policymakers to dispense with their silly fixation on a financial transactions tax and instead repair their broken banking systems and use all monetary and fiscal means at their disposal to jump-start economic growth.

I've supported this tax mainly because it helps to overcome a market failure. If it produces revenue at the same time, so much the better.

Wednesday, February 08, 2012

I have been more optimistic than most about the return to long-run trend, i.e. that the shock we experienced is mostly temporary rather than permanent, but here's another view arguing that we have had a substantial decline in the natural rate of output:

This speech is really about how to interpret the recent performance of the U.S. economy. Is the conventional interpretation, that we are far below "potential" GDP owing to "deficient demand," the correct view? Or should we instead be thinking in terms of a large negative shock to "potential" GDP, with unemployment returning slowly to its natural rate, according to its normal dynamic (see here)?

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along its original growth path). The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.

The view that one takes here is likely to influence what one thinks about monetary policy. The conventional view seems to support the Fed's current policy of keeping its policy rate close to zero far into the future. In his speech, Bullard worries that this may not be the appropriate policy if, in fact, potential GDP has experienced a level shift down (or, what amounts to the same thing, if conventional measures treat the "bubble period" as the economy being at, and not above, potential). Among other things, he says:

But the near-zero rate policy has its own costs. If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy. But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.

Precisely how such a policy "distorts fundamental decision-making" needs to be spelled out more clearly (though he does offer a couple of examples that hinge on a presumed ability on the part of the Fed to influence long-term real interest rates). I am sure that many of you have your own favorite examples.

At any rate, I think this is a nice speech because it challenges us to think about the recent U.S. recovery dynamic in a different way. And if recent history has shown us anything, it's shown that we shouldn't grow complacent over what we think we understand.

I believe that costs are asymmetric -- doing too little to help the economy is worse than doing too much -- and the conclusion that the shock is mostly permanent rather than temporary is more likely to lead to policymakers giving up too soon (resulting in the more serious error). Thus, those that hold this view need to recognize the asymmetric nature of the mistakes they are likely to make and adjust their policy recommendations accordingly.

However, inflation hawks see the costs as more symmetric, and they are convinced the shock is mostly permanent, so they would disagree with the need to adjust their policy recommendations. But as noted above, I think the shock is highly persistent but ultimately mostly temporary, and I just don't see the equivalence between a marginal increase in inflation versus a marginal decrease in unemployment. For me, unemployment is a much higher priority (and yes, I understand the argument that inflation problems ultimately impact employment).

Update: There are two concerns here that I may not have done enough to separate in the comments above. First, there is the concern that the asymmetric nature of the costs of inflation and unemployment is being ignored in policy recommendations (though, again, inflation hawks see inflation as more costly than I do, and hence see the costs as more symmetric, and they believe that a short burst of inflation to fight a recession is likely to lead to a long-run inflation problem -- I have more faith in the Fed than that). This means, for me anyway, that policy ought to tilt toward unemployment (i.e., I disagree with Ben Bernanke's recent assertion in testimony before Congress that inflation and unemployment should be and are weighted equally).

The second concern is the assumption that the natural rate has fallen permanently. Making this assumption when in fact the shock is largely temporary will lead to a miscalculation of the chance that we will face an inflation problem -- the calculated odds will be too high -- and the undue fear of inflation will cause policy to tighten too soon. This results in an error where unemployment rather than inflation is higher than desired. The opposite belief -- the belief that the shock is temporary when it turns out to be permanent -- leads to the opposite policy error, i.e. unemployment lower and inflation higher than desired, but to me that is more tolerable. That's not why I hold the view it's mostly a temporary shock -- that's a conclusion based upon economic considerations -- but given that the costs are asymmetric the belief that the shock is temporary does result in a less serious policy error if it is wrong.

Stressing the importance for the country to provide cheap energy to its citizens, Santorum blamed the recession not on sub-prime mortgages or the derivatives market but on spiking fuel prices.

“We went into a recession in 2008. People forget why. They thought it was a housing bubble. The housing bubble was caused because of a dramatic spike in energy prices that caused the housing bubble to burst,” Santorum told the audience. “People had to pay so much money to air condition and heat their homes or pay for gasoline that they couldn’t pay their mortgage.”

Hmmm.

Now we are all used to Republican pols treating gasoline prices as some sort of ultimate, can’t miss issue that trumps everything else. And it is refreshing to find a GOP presidential candidate who isn’t explicitly or implicitly claiming our economic problems were caused by hordes of shiftless poor and minority folk who conspired with ACORN and Freddie and Fannie to take out mortgages that had no intention of paying. But the idea that gasoline and home heating costs caused the whole mess is a new one to me...

So the way to prevent future housing bubble problems is, of course, to deregulate the energy industry.

The Sad Spectacle of Obama’s Super PAC, by Robert Reich: It has been said there is no high ground in American politics since any politician who claims it is likely to be gunned down by those firing from the trenches. That’s how the Obama team justifies its decision to endorse a super PAC that can raise and spend unlimited sums for his campaign.

Baloney. Good ends don’t justify corrupt means.

I understand the White House’s concerns. ... The White House was surprised that super PACs outspent the GOP candidates themselves in several of the early primary contests, and noted how easily Romney’s super PAC delivered Florida to him and pushed Newt Gingrich from first-place to fourth-place in Iowa.

Romney’s friends on Wall Street and in the executive suites of the nation’s biggest corporations have the deepest pockets in America. ... “With so much at stake” wrote Obama campaign manager Jim Messina on the Obama campaign’s blog, Obama couldn’t “unilaterally disarm.”

But would refusing to be corrupted this way really amount to unilateral disarmament? To the contrary, I think it would have given the President a rallying cry that nearly all Americans would get behind: “More of the nation’s wealth and political power is now in the hands of fewer people and large corporations than since the era of the robber barons of the Gilded Age. I will not allow our democracy to be corrupted by this! I will fight to take back our government!”

Small donations would have flooded the Obama campaign, overwhelming Romney’s billionaire super PACs. The people would have been given a chance to be heard. ...

One Obama adviser says Obama’s decision to endorse his super PAC has had an immediate effect. “Our donors get it,” the official said, adding that they now want to “go fight the other side.”

Exactly. So now a relative handful of super-rich Democrats want fight a relative handful of super-rich Republicans. And we call that a democracy.

The rules on campaign finance need to change. Political influence and power is too concentrated already and as noted in a part of Reich's post that I left out, president Obama hasn't done much to encourage reform. But given the rules that are in place, and my doubts that a surge of small donations would really overwhelm PACs, I'm not so sure this is a bad decision. I'd be curious to hear what you think.

Tuesday, February 07, 2012

I assume and hope this would be vetoed by the president Obama, but the effort itself is telling:

Tilting the Budget Process to the G.O.P.,by Bruce Bartlett, Commentary, NY Times: The House of Representatives voted last week to tilt the budgetary process in favor of the Republican economic agenda. On Feb. 3, the House passed ... the Pro-Growth Budgeting Act of 2012. Innocuous on the surface, its long-term purpose is to institutionalize Republican economic policy into the very fabric of budgetary analysis.

The legislation would require that the Congressional Budget Office and Joint Committee on Taxation do a “dynamic” analysis of major legislation.... The dynamic calculation would be supplementary and not replace the current official scoring methodology, but the obvious long-term goal is to require official revenue estimates to incorporate “Laffer curve” effects in order to make it easier to cut taxes and harder to raise them...

As the budget deficit increasingly inhibits Republicans’ tax-cutting, they are planning ahead for tax cuts that they will insist are costless because they will so massively increase growth. ... My concern is that the Republican effort is just a smokescreen to incorporate phony-baloney factors into revenue estimates to justify unlimited tax cutting. How soon before the C.B.O. is required to incorporate estimates from the right-wing Heritage Foundation in its calculations? ... Republicans don’t really care about accurate revenue estimates; they just want them to show that tax cuts pay for themselves...

Confirmation of this fear is the fact that the House-passed legislation would not require a dynamic estimate for appropriations bills, no matter how large. Republicans want the world to know that tax cuts expand real G.D.P., the capital stock and labor supply, but if spending has any such effect they don’t want anyone to know. Implicitly, Republicans want everyone to think that spending never raises growth because it’s their dogma.

But in the real world, everyone knows that government investments in the national highway system, medical and other scientific research, and other programs unquestionably add to growth. ...

Over the last three years, we have seen Republicans politicize every aspect of policy making... It is reasonable to assume that the Republicans’ effort to alter the budget process is just another aspect of their goal to politicize policy and institutionalize their philosophy.

I don't have any problem with the CBO incorporating growth effects into its estimates of the impact of policy (for both spending and taxes), but the CBO should not be forced to adopt a particular macroeconomic model or methodology for evaluating policy. That's a recipe for partisan analysis -- we see that already with infrastructure excluded from the calculations -- where a neutral voice is needed. As I said above, I expect the legislation would be vetoed by president Obama, but a president Romney would be a different story.

[This] map... — taken from here — tells us that overall, exports to Europe are just 2 percent of GDP..., even a sharp fall in exports to Europe would be only a small direct hit to demand.

OK, caveats: this only measures goods exports, and we should mark the numbers up maybe 25 percent to take account of services. Also, exports aren’t the only channel: if European events cause a Lehman-type event, disrupting financial markets world-wide, all bets are off.

And I should say that there is a long-standing puzzle concerning world business cycles: economies move in synch more than can easily be explained via concrete linkages in the form of exports.

With all that, however, it’s still very questionable whether Europe’s looming recession will actually have that much negative impact here. Decoupling didn’t hold in 2008-2009, but that was an epochal disaster. This time might be different.

Bean, 36, lost his job in December. ... Bean’s predicament is not unlike that of many workers who have a high school education or less. Not only were they hit especially hard by the recession, they also have continued losing ground in the recovery that has followed.

By disproportionate numbers, these Americans have given up looking for work, making the nation’s recovery appear better than it is. ...

The number of Americans facing this predicament isn’t small. Nearly a third of the nation’s labor market has only a high school diploma. ... The news is worse for high school dropouts. ...

The recovery, economists say, has highlighted the consequences of not earning a college degree. ... The improvements that have occurred since the start of the recovery have accrued mostly to better-educated workers, analysts say. The economic challenge that lies ahead is finding a new place for workers such as Bean, who lack advanced academic credentials. Many of them rely on community colleges for their training, but those budgets have been cut in recent years. ...

It's easy to imagine Congress forgetting about this group (even more than it already has).

Monday, February 06, 2012

A quick post between appointments -- Joe Stiglitz is unhappy with the ECB. He says, "The ECB’s behavior should not be surprising: as we have seen elsewhere, institutions that are not democratically accountable tend to be captured by special interests":

Capturing the ECB, by Joseph Stiglitz, Commentary, Project Syndicate: Nothing illustrates better the political crosscurrents, special interests, and shortsighted economics now at play in Europe than the debate over the restructuring of Greece’s sovereign debt. Germany insists on a deep restructuring – at least a 50% “haircut” for bondholders – whereas the European Central Bank insists that any debt restructuring must be voluntary.

In the old days – think of the 1980’s Latin American debt crisis – one could get creditors, mostly large banks, in a small room, and hammer out a deal, aided by some cajoling, or even arm-twisting, by governments and regulators eager for things to go smoothly. But, with the advent of debt securitization, creditors have become far more numerous, and include hedge funds and other investors over whom regulators and governments have little sway.

Moreover, “innovation” in financial markets has made it possible for securities owners to be insured, meaning that they have a seat at the table, but no “skin in the game.” They do have interests: they want to collect on their insurance, and that means that the restructuring must be a “credit event” – tantamount to a default. The ECB’s insistence on “voluntary” restructuring – that is, avoidance of a credit event – has placed the two sides at loggerheads. The irony is that the regulators have allowed the creation of this dysfunctional system.

The ECB’s stance is peculiar. ... There are three explanations for the ECB’s position, none of which speaks well for the institution and its regulatory and supervisory conduct. ...[continue reading]...

In response to Tyler Cowen, if the alternative hypothesis to his null that Old Keynesian models have failed is New Keynesian models, and he has rejected the Old in favor of the New, then I don't have many problems with his overall conclusion (which is not to say I agree with every detail of his argument). I thought his alternative hypothesis was broader than just the New Keynesian model, i.e. that he was arguing against Keynesian models of all varieties, but he says "I very much prefer New Keynesianism over Old." So if he is really saying the data support the New Keynesian model, I don't have much to disagree with. (See here for a post highlighting the difference between Old and New Keynesian IS-LM models. I posted this when people tried to claim I support Old Keynesian models as a way of discrediting what I have to say, and I've posted lots of New Keynesian work on fiscal multipliers as well. But people like Williamson, who Tyler points to authoritatively for reasons that escape me, still make the false charge that I promote old-fashioned Keynesian ideas.)

A few notes:

People seem to forget that the federal fiscal policy efforts were almost entirely offset by declines in spending and/or tax increases at the state and local level. Given that, it's not clear why we should expect to see a big effect in the data on output and employment. Fiscal policy at the federal level simply stopped things from getting even worse that they already were -- the bottom would have been much worse without it. Thus, when natural recovery finally began to take hold, it did so from a higher base than without the federal effort (and perhaps started sooner). Think of it this way -- fiscal stimulus allowed us to hold ground we would have lost otherwise -- again things would have been much worse without it -- until the natural recovery process was ready to begin.

I don't see how the fact that the economy is presently recovering at a rate where we will get to full employment by 2019 (or a few years earlier with very optimistic projections) says much about the effectiveness of fiscal policy. It kept things from getting worse, then it ran out, and now we are still looking at a relatively slow recovery by historical standards. What we want to know, but won't find out due to opposition in Congress, is if the recovery would be even faster from this point forward with additional fiscal policy efforts. Nobody ever said the economy wouldn't recover without stimulus, it's the rate of recovery that is at issue. Past efforts have kept GDP and employment from declining even more and made it easier for the natural recovery process to take hold, and additional fiscal policy timed correctly could have helped even more.

On the "timed correctly" point, people also seem to forget about policy lags. The same people who were arguing that infrastructure spending would take too long, that by the time it took hold the economy would already be recovering and it wouldn't be needed, now criticize policy as though it happens instantaneously. It doesn't. How much of the recovery is being driven by the lagged effects of our fiscal policy efforts? That will need to be teased out of the data -- a difficult task since monetary policy easing was going on at the same time and those effects have to be separated from fiscal policy and other factors that affect output and employment. For example, a firm that sees extra spending as a result of tax cuts may do a bit better than otherwise, and then decide to invest in an expansion of the business. It takes time to realize things are a bit better, plan the expansion, and then build it. The expansion is properly attributed to fiscal policy efforts, but this is very hard to see in the data (note that many of the tax measures are still in place, and that spending can also generate these types of effects). Tyler says "Frankly, it is a bit of an embarrassment for many commentators that the (admittedly weak) recovery is coming right after the end of the fiscal stimulus," but I don't see why that necessarily proves the case. Again, past policy efforts allowed us to take off from a higher base, and likely sooner than otherwise, and policy lags (plus the continuation of many tax breaks) imply that fiscal policy could still be active. I think the main effect of fiscal policy was to stop things from getting worse, I am not saying that fiscal policy is still necessarily present to a significant extent, only that we can't rule out that it is still helping without doing the economtric analysis.

Finally, in passing, liquidity traps exist, at least in theory, in both Old and New versions of the model (e.g. see the discussion in Carl Walsh's text on monetary economics). I disagree on with Tyler's point on the liquidity trap -- I think the evidence suggests we did enter a liquidity trap and that it is still a problem -- but in any case the failure to find a liquidity trap does not distinguish one model from the other (though to be fair, it's possible to construct versions of both models where a liqudity trap does not exist, but this is easier in the New Keyneisan model than in thye Old).

We seem to have turned the corner, but policymakers should not relax yet -- we still have a long way to go to get back to full employment:

Things Are Not O.K., by Paul Krugman, Commentary, NY Times: ...So, about that jobs report:... for once falling unemployment was the real thing, reflecting growing availability of jobs rather than workers dropping out of the labor force... That said, our economy remains deeply depressed. As the Economic Policy Institute points out,... even at January’s pace of job creation it would take us until 2019 to return to full employment.

And we should never forget that the persistence of high unemployment inflicts enormous, continuing damage on our economy and our society,... in particular,... that long-term unemployment ... means more Americans permanently alienated from the work force, more families exhausting their savings, and, not least, more of our fellow citizens losing hope.

So this encouraging employment report shouldn’t lead to any slackening in efforts to promote recovery. ... Policy makers should be doing everything they can to get us back to full employment as soon as possible.

Unfortunately, that’s not the way many people with influence on policy see it. Very early in this slump — basically, as soon as the threat of complete financial collapse began to recede — a significant number of people within the policy community began demanding an early end to efforts to support the economy. Some of their demands focused on the fiscal side, with calls for immediate austerity... But there have also been repeated demands that the Fed ... raise interest rates.

What’s the reasoning behind those demands? Well, it keeps changing. Sometimes it’s about the alleged risk of inflation... And the inflation hawks ... seem undeterred ... by the way the predicted explosion of inflation keeps not happening...

But there’s also a sort of freestanding opposition to low interest rates, a sense that there’s something wrong with cheap money and easy credit even in a desperately weak economy. I think of this as the urge to purge, after Andrew Mellon, Herbert Hoover’s Treasury secretary, who urged him to let liquidation run its course, to “purge the rottenness” that he believed afflicted America.

And every time we get a bit of good news, the purge-and-liquidate types pop up, saying that it’s time to stop focusing on job creation. ... And the sad truth is that the good jobs numbers have definitely made it less likely that the Fed will take the expansionary action it should.

So here’s what needs to be said about the latest numbers: yes, we’re doing a bit better, but no, things are not O.K. — not remotely O.K. This is still a terrible economy, and policy makers should be doing much more than they are to make it better.

Another Experiment?, by Tim Duy: In the fall of 2008, US authorities conducted a financial market experiment. They allowed a large and heavily interconnected firm, Lehman Brothers, to file for bankruptcy, apparently under the belief that the consequences should be limited as everyone knew this was coming. I think that, in retrospect, US policymakers wished they had pursued an alternative path. The experiment was not exactly successful.

Now it seems that European policymakers are willing to risk yet another such experiment. To be sure, they could still pull the rabbit out of the hat, but it is starting to look like the Troika and Greece have was they call in divorce court "irreconcilable differences." Via the Financial Times:

Lucas Papademos, the Greek premier, failed to make party leaders accept harsh terms in return for a second €130bn bail-out, pushing Athens closer to a disorderly default as early as next month...

...After five hours of discussions, the three leaders of Greece's national unity government had not accepted demands by international lenders for immediate deep spending cuts and labour market reforms as part of a new medium-term package.

The Troika does not look ready to back down either:

The talks with the three leaders of a national unity government came after the government failed to persuade the so-called “troika”– representatives of the European Commission, European Central Bank and International Monetary Fund – to ease conditions for the rescue deal.

Patience with Greek politicians has evaporated among its creditors. During a conference call on Saturday, eurozone finance ministers bluntly told Athens to deliver on its promises and agree to reforms or face default next month.

Apparently, the Troika is playing serious hardball:

Eurozone officials are deliberately refusing to allow Greece to sign off on a €200bn bond restructuring plan because the threat of default is the leverage they have to convince recalcitrant Greek ministers to implement necessary cuts.

Now, perhaps Greece's leaders are just putting up a fight to look good to their voters and thus this will all blow over tomorrow morning with another last minute deal cobbled together that no one really believes will work. Indeed, everyone already knows the numbers are too small:

A further complication is the uncertainty over supplementing the €130bn bail-out to take account of the deteriorating economic position in Greece.

Some officials believe around another €15bn is needed – funds that Germany and other countries have said they are unwilling to provide.

It doesn't really make sense for Greece to accept a deal they know is doomed to failure from the start. Especially as the terms of the deal - including a steep wage cut to improve competiveness - is virtually guaranteed to plunge the Greek economy deeper into recession.

Fundamentally, the problem is as it always was - any decent adjustment program has the stick and the carrot. The carrot usually comes partly in the form of a currency devaluation that accelerates the process of adjustment by providing stimulus via the external accounts. This short-run stimulus allows for structural changes to take root. The approach to Greece has always been just the stick - more austerity and structural change, no carrot.

And I have to admit that I find the enforced wage-cutting a draconian solution. Will this policy eventually be applied to Spain and Portugal and Ireland? Is this the future of Eurozone economic policy? There are two ways to reduce competitive imbalances. Inflate German wages up, or deflate everyone else down. I think the former would prove to be a lot more fun than the latter.

Truth be told, I honestly believe that Greece is beyond saving without a significant transfer, not loan, that buys real time for the Greek economy to adjust. That is the only way to compensate for the lack of currency adjustment and is the conclusion I wish the Troika would ultimately reach. But, I am also starting to think that the ECB has made the Troika overconfident. When the ECB finally decided that yes, serving as lender of last resort, at least to the financial system, is actually the job of a central bank, they dramatically eased financial market stress throughout Europe. That stress, however, was Greece's leverage. Absent that stress, the Troika appears to believe Greece is backed into a corner with no other way out but to submit to Troika demands.

This is a dangerous game. Sometimes the person backed into a corner makes a sucide run at their attackers. And maybe Greece has nothing else to lose at this point. To be sure, they will suffer a devastating blow if they exit the Euro, but at least it will be the process of self-determination, rather than the devastating blow of Troika imposed austerity.

And, while I am thinking about it, what exactly is the policy precedent the Troika is trying to set? That it is acceptable to force European citizens - a whole people - into poverty? When does this become a human rights issue?

In any event, I don't think financial market participants are really prepared for Greece to make a suicide run. Why should they be? This whole episode is like The Boy Who Cried Wolf. Everytime we come to the brink, and prognosticators call for the apocalypse, someone backs down. Why should this time be any different? Honestly, it is tough to argue with that logic. Expectations of imminent financial crisis have simply gone unmet, leaving markets relatively unphased by the most recent events in Greece. Perhaps the ECB haas done enough to let Greece slide out of the Euro without much noise.

It would be an interesting experiment to see unfold. I am curious to see if the ECB has indeed done enough. Not curious enough, however, to want to take such a risk. The Boy Who Cried Wolf ultimately had a poor ending.

Sunday, February 05, 2012

Prospects for Nuclear Power, by Lucas W. Davis, NBER Working Paper No. 17674, December 2011: The prospects for a revival of nuclear power were dim even before the partial reactor meltdowns at the Fukushima nuclear plant. Nuclear power has long been controversial because of concerns about nuclear accidents, proliferation risk, and the storage of spent fuel. These concerns are real and important. In addition, however, a key challenge for nuclear power has been the high cost of construction for nuclear plants. Construction costs are high enough that it becomes difficult to make an economic argument for nuclear, even before incorporating these external costs. This is particularly true in countries like the United States where recent technological advances have dramatically increased the availability of natural gas.

Christina Romer says the case for promoting manufacturing is less than fully convincing:

Do Manufacturers Need Special Treatment?, by Christina Romer, Commentary, NY Times: Everyone seems to be talking about a crisis in manufacturing. Workers, business leaders and politicians lament the decline of this traditionally central part of the American economy. President Obama, in his State of the Union address, singled out manufacturing for special tax breaks and support. Many go further, by urging trade restrictions or direct government investment in promising industries.

A successful argument for a government manufacturing policy has to go beyond the feeling that it’s better to produce “real things” than services. American consumers value health care and haircuts as much as washing machines and hair dryers. And our earnings from exporting architectural plans for a building in Shanghai are as real as those from exporting cars to Canada.

The economic rationales for a policy aimed specifically at shoring up manufacturing largely fall into three categories. None are completely convincing: Market Failures ..., Jobs ..., Income Distribution ...

As an economic historian, I appreciate what manufacturing has contributed to the United States. It was the engine of growth that allowed us to win two world wars and provided millions of families with a ticket to the middle class. But public policy needs to go beyond sentiment and history. It should be based on hard evidence of market failures, and reliable data on the proposals’ impact on jobs and income inequality. So far, a persuasive case for a manufacturing policy remains to be made...

[I probably should have noted that I said something similar in my last column, i.e. "Manufacturing ... is not the only path to a better future. We need a strategy that creates the conditions for new, innovative firms of all sorts rather than focusing too much on any one area."]